Corporate debt financing and earnings quality

Aloke Ghosh, Doocheol Moon

Research output: Contribution to journalArticle

39 Citations (Scopus)

Abstract

Our study establishes linkages between two extensively researched areas, debt financing and the quality of earnings. Debt can have a 'positive influence'on earnings quality because managers are likely to use their accounting discretion to provide private information about the firms' future prospects to lower financing costs. For high debt, it can also have a 'negative influence' on earnings quality as managers use accruals aggressively to manage earnings to avoid covenant violations. Using accruals quality as a proxy for earnings quality, we document a non-monotonic (curvilinear) relation between debt and earnings quality. The relationship is positive at low levels of debt and negative at high debt levels with an inflection point around 41%. Our results suggest that firms that rely heavily on debt financing might be willing to bear higher costs of borrowing from lower earnings quality because the benefits from avoiding potential debt covenant violations exceed the higher borrowing costs.

Original languageEnglish
Pages (from-to)538-559
Number of pages22
JournalJournal of Business Finance and Accounting
Volume37
Issue number5-6
DOIs
Publication statusPublished - 2010 Jun

All Science Journal Classification (ASJC) codes

  • Accounting
  • Business, Management and Accounting (miscellaneous)
  • Finance

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